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Incomplete contracting, renegotiation, and expectation-based loss aversion

Author

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  • Herweg, Fabian
  • Karle, Heiko
  • Müller, Daniel

Abstract

We consider a simple trading relationship between an expectation-based loss-averse buyer and a profit-maximizing seller. When writing a long-term contract the parties have to rely on renegotiation in order to ensure materially efficient trade ex post. We show that if the buyer expects renegotiation to occur, the seller can opportunistically exploit the buyer's attachment to the expected outcome of renegotiation. In other words, incomplete contracts create a new type of hold-up problem. If credible, the buyer prefers to expect not to renegotiate, which gives rise to ex post inefficiencies. In a next step, we allow the buyer to undertake a non-contractible investment. We find that loss aversion can mitigate the traditional hold-up problem.

Suggested Citation

  • Herweg, Fabian & Karle, Heiko & Müller, Daniel, 2018. "Incomplete contracting, renegotiation, and expectation-based loss aversion," Journal of Economic Behavior & Organization, Elsevier, vol. 145(C), pages 176-201.
  • Handle: RePEc:eee:jeborg:v:145:y:2018:i:c:p:176-201
    DOI: 10.1016/j.jebo.2017.07.033
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    References listed on IDEAS

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    More about this item

    Keywords

    Behavioral contract theory; Expectation-based loss aversion; Hold-up problem; Incomplete contracts; Renegotiation;

    JEL classification:

    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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